Lets state it up front. There is a single tip that will allow you to avoid almost all the frauds – just one. The tip is this:

Do not invest in a fund where the fund manager has access to your assets.

Ok – that needs a little explaining but its not complicated. If – as an American - you invest in Bronte Capital you don't give us the money. We are not even legally allowed to take it. You send the money to Citco. Citco is the world's largest hedge fund outsource company – but there are alternatives. David Einhorn's Greenlight Capital uses one of the bigger banks. There are smaller players such as Spectrum, Conifer and others.

When you send the money to Citco they hold the assets. We just trade them by issuing instructions to brokers. However if we asked Citco to send the money to our personal bank account they would (rightly) refuse. Moreover Citco value our assets every month and they – not us – send the statements to the clients. We don't do the valuation so we can't fake it. We don't hold the assets so we can't steal them.

Private clients surprisingly don't get this. One of my friends runs a successful (albeit small) fund from his home. People regularly make out checks out to him. (If you send us money we will say thank you and send it back...) The core due diligence test is simply not understood by retail clients – and alas the Wall Street Journal perpetuates their ignorance.

And guess who was the custodian for the assets invested in Bernie Madoff's fund. BMIS – and that stood for Bernie Madoff Investment Securities. And Bayou- another large fraud. Well Bayou of course. How about Astarra – the fraud I exposed in Australia. Well their custodian was Trio Capital – a small custodian in the rural Australian town of Albury. And guess what – Trio and Astarra had the same owners! What about New World Capital Management – a fraud I wrote up but which was never prosecuted: well the perpetrator himself of course. I could go on and on and on. It is really easy to spot frauds and the fact they keep reappearing is testament to people not having a clue how to look for one.

If there is a single due diligence lesson then it is this: ensure that your money mangers have an independent custodian and preferably one of the majors. And the first step in due diligence is this: don't do your due diligence on the fund manager – do it on the custodian. Ring the custodian through their switch (not on a phone number provided by the fund manager) and confirm statements of the fund manager with the custodian.*

If you do this you are unlikely to get fleeced. Simple as that.

Rob Curran misguidedly – and in the interest of the financial establishment tells you what his first red-flag in assessing managers is. I quote:

The Fund Came to You: The Fund Came to You: While it's not unheard of for a hedge fund to approach a wealthy individual, reputable funds usually concentrate their prospecting on institutional investors, says Randy Shain, executive vice president of First Advantage Litigation Consulting, who has been looking into hedge funds for 20 years. Always ask for the names of a fund's institutional investors, then contact them to verify that they are investors and have no qualms about the fund's legitimacy. While it's not unheard of for a hedge fund to approach a wealthy individual, reputable funds usually concentrate their prospecting on institutional investors, says Randy Shain, executive vice president of First Advantage Litigation Consulting, who has been looking into hedge funds for 20 years. Always ask for the names of a fund's institutional investors, then contact them to verify that they are investors and have no qualms about the fund's legitimacy.

Well politely – garbage. I have written before on how institutional investors are right people to contact when you want to move the fund from $500 million under management to $1.5 billion under management. They are absolutely useless at finding the hot fund manager with $5 million under management on their way to five years of 30 plus percent returns. If you used this rule you would never have invested with Warren Buffett when he ran Buffett partnership. All of the Buffett biographies make clear he approached well-to-do people like local medical specialists.

But its worse. If you invest in managers that come to you through funds of funds or institutions you will probably wind up paying double-layer fees to get something like the average of all hedge fund managers. Our initial client sent us the multi-fund manager record for a major (and successful) fund of fund.

(Click to expand).

He thought this these returns were BS. I was kinder – these returns ok relative to equities over the same period – and more stable and probably ex-ante lower risk – so I believe this fund of funds has added value. But the returns are not what you get from a couple of clever guys doing smart stuff. Moreover there is a real danger in going through the institutional managers – which is that you get something that averages near the financial consensus. And being in a crowd on Wall Street feels safe but it is actually shockingly dangerous.

Anyway my summary is that the number one method of choosing a fund given by Rob Curran (that is avoid one that comes to you) is counterproductive. And the number one method of proving you are not defrauded rates a very thin method in the Rob Curran article.

And the Rob Curran article annoys me too – because at Bronte we are careful about trying to construct portfolios without regard to the consensus. We don't look like institutional managers (no suits). We don't sound like institutional managers (those accents). And we we don't think like institutional managers (we don't like style boxes and we will happily change styles if market conditions change). Rob Curran is telling all the WSJ readers to avoid funds like Bronte or Kerrisdale or any of the other thoughtful start-ups out there.** And if this criticism sounds a little strident then it should be. He is defending the financial consensus and the big institutions and frankly I don't think the big institutions covered themselves with glory over the last five years.

Secondary steps to chose the individual hedge fund

You know my view – the really good fund managers are outside the consensus. Ratbags if you will – but ratbags with risk control. Danny Loeb was a tearaway when he was younger. [The rumor is that he posted more than 100 thousand messages on chatboards under the moniker of Mr Pink.] David Einhorn might look like he is 18 (he is preternaturally young) but listen to what he says and he throws grenades. (Who can forget the stoushes with Allied Capital and Lehman Brothers?) And these guys are really smart. And I guess if you want to chose a hedge fund and you don't want to work too hard you could ring them up. In the mutual fund space my old boss at Platinum in Australia is far less out-there than those two but he is super-smart and he is not afraid to have people disagree with him.

But you would have missed Einhorn and Loeb when they were young and their best returns were mostly when they managed relatively small amounts of money. Being an initial year investor in either of these funds was frightfully good. [Incidentally Buffett's best returns were also when he was younger and smaller. Buffett partnerships returns were substantially better than Berkshire Hathaway.]

So how do you chose a smaller manager?

Well first remember my test: do they hold the assets themselves of give them to a reputable third party to hold. Don't forget this rule – it solves almost everything.

Then ask how they get the returns. Leverage levels matter (they should be low – but 120 long 40 short is probably less risky than just 100 long). Position size matters. Short positions should generally be small (or using other mechanisms that limit risk like shorting debt rather than equity). Long positions can be (much) larger.

Then ask them questions. Pick an industry that you know really well and they profess to know. If you can't do that work out some other mechanism to check out that they are not talking through their posterior. (Clever and well thought through shareholder letters are a good start. A blog is not bad either!)

Finally there is a test which I do (and which has enabled me to see many frauds) but that is seldom done elsewhere. Match the stated returns to the ex-ante stated positioning. For example I have disclosed several times on this blog that I am interested in shorting fraudulent Chinese stocks. It should then come as no surprise that we are doing (very) well this month.

Likewise alas it was well known that Bank of America was our biggest position as it fell back from the 19s to the 11s. Bank of America was above 19 in March 2010. Here are our returns:

(These returns are for a separately managed account for our foundation client.)

The Bank of America position wasn't the only reason for the dud-period in the middle. We are a global fund and measure ourself in US dollars. The US dollar appreciated sharply through that period (devaluing our largish Euro denominated positions). We quite explicitly generally do not hedge currency so you would expect to see currency volatility in our returns. We also had a position in Maguire Preferred (now MPG Preferred) which gave us a wild though profitable ride.

More to the point – this was done primarily with big cap long positions (and small profitable positions in some defaulted preferred securities) and highly diversified and usually small cap shorts. The positioning is as explained in my lament post.

Finally I have some strong views about prime brokers. You should use only funds with US domiciled prime brokers for the reasons outlined in this post.

In other words it is pretty easy to do due diligence on us.

Incidentally the question we are asked almost all the time is "how much money do you manage?" The implication that you need to be large to be good. I assure you in almost every case returns are negatively correlated to funds under management. You want the answer to be low - another inversion of the normal presumption. Large however is the comfort of crowds - a comfort misplaced in markets.

Here are the steps generalized for any small gun hedge fund manager you might want.

Step 1: Check the independence of the asset custodian. This is a black-and-white test. Any gray in the answer then the fund fails. Period. Actually if it fails email enforcement@sec.gov and see if you can get bounties for spotting it.

Step 2: Are they smart? Test them on some industry. Bring an expert if you have one. Otherwise carefully read their material.

Step 3: Do they keep the position size and the leverage low enough to be safe? Shorts must be smaller than longs.

Step 4: Do their returns correlate with what they say? Focus on the particularly good months and the flat months.

Step 5: Is their brokerage arrangement sound (especially do they use US domiciled prime brokers).

And if you are a rich guy and they ring you out of the blue. They are either trying to steal from you or they are being entrepreneurial. Entrepreneurial is good – sometimes very good.

Follow the above steps and you will sort the wheat from chaff.

Is it too much to ask the Wall Street Journal to do the article properly next time?

John

*If you ring the custodian at a phone number provided by the money manager you could find yourself talking to a Potemkin custodian – just as people who rang advertising agencies at phone numbers provided by CCME would up talking to Potemkin advertising agencies. No kidding. When someone gives you a reference do not ring the number they give you – ring the switchboard of the company they work at. Always.

**Kerrisdale is far more aggressive than Bronte. Their returns are better too. But I have wondered openly whether aggression and risk are actually that well correlated - and I would use them as a case example. I have conducted none of the tests described here on Kerrisdale.

I've always had a fondness for Australia and since stumbling onto your blog 2 years ago I have an even deeper fondness. I have a small put position that looks like it will pay off on CAGC and if I'm ever in Aussie land I'll buy you a beer. With that said I do have 3 questions. Do you always use short vs. puts? If so, why? Lastly do you post on Yahoo message boards? I have seen a jlhempton post occasionally. I normally feel my IQ heading south when I read or post but sometimes I'm entertained and educated.

Dear John- I allocate to hedge funds for a living, and I generally agree with all your comments. There is one thing that you said and I don't get though: that shorts must be smaller than longs. If you are talking about the aggregate position, well, I think it is a general market call and therefore should not be systematically one-sided.

If you are talking about individual position size, I don't see why it should be the case (unless you have a very concentrated portfolio, in which case shorts might grow on you a bit too quickly when wrong). I generally consider that a similar approach to longs and shorts is a sign of a true absolute return mindset.

Additionally- I would add to your list the importance of checking the quality and the robustness of leverage. For example- If you are a Long-Short manager, I would try and understand how and when your Prime Broker could unilaterally change the terms of funding: generally, unless this was negotiated otherwise, PBs have the ability to pull the plug overnight. When you run a large balance sheet in illiquid markets (credit, small caps) this is a significant risk.

Thanks for your efforts on this blog- I always enjoy reading your posts.

I really think you should start publishing your findings more often. (1) By now, it is outright open season on the Chinese reverse-merger scams(2) You have built enough credibility to move the market (not just CAGC and UTA but in general)(3) While obviously self-serving, this will focus more people on the stock> this is good as there might be valid arguments against your thesis, or alternatively, valid additions

always a pleasure to read your posts. however, I have one comment on your preference for smaller hedge funds. couldn´t it be survivor-bias that the current well-respected funds did so well in their early years? i.e. it was a great time to invest in them. but then, how many of their rivals went bust? maybe there is some research out there that could prove or disprove your thesis.

on the other hand, I agree with your comment on using puts vs shorts. as a stock option´s market maker it is almost always a great time to be short premium, because people like to overpay for the insurance. big shorts can be very painful too, but disasters don´t happen too frequently. it is painful to see puts expire time after time, bleeding more cash in the long run, than taking a major hit once in a while (as long as it doesn´t kill you).

The portfolio we have (and hence our returns) would not be possible with billions under management.

Having worked at a shop that manages 20 billion I can assure you to do it well is amazingly hard work. I am not sure I want to go there - and frankly the team does not currently have the skills to go there.

I would like to open an Australian domiciled hedge fund at some stage - but am unwilling to cut the fees to do it and the establishment costs are high which means we will only do it if worthwhile. But hey if you want to talk?

When you say "asset custodian" are you referring to the administrator? I am U.S. based, and the administrator handles investor inflows/outflows as well as reporting performance to investors. I am not sure if they are synonymous or you're referring to something different.

Regarding Custody: If a small fund, that in almost every way satisfies the requirements...custodies the money at their Prime Broker which is a well known company, is this satisfactory? Or should the fund add yet a further level of separation?

General disclaimer

The content contained in this blog represents the opinions of Mr. Hempton. Mr. Hempton may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Hempton's recommendations. The commentary in this blog in no way constitutes a solicitation of business or investment advice. In fact, it should not be relied upon in making investment decisions, ever. It is intended solely for the entertainment of the reader, and the author. In particular this blog is not directed for investment purposes at US Persons.